Linear Accounting Valuation When Abnormal Earnings Are AR(2)

Linear Accounting Valuation When Abnormal Earnings Are AR(2) The Ohlson (1995) model assumes that abnormal earnings follow an AR(1) process primarily for reasons of mathematical tractability. However, the empirical literature on the Garman and Ohlson (1980) model finds that the data support an AR(2) lag structure for earnings, book values and dividends. Moreover, the AR(2) process encompasses a far richer variety of time series patterns than does the AR(1) process and includes the AR(1) process as a special case. This paper solves the Ohlson model directly for an AR(2) abnormal earnings dynamic. The model is estimated on a time series firm-level basis following the approach used by Myers (1999). It is found that, like the Ohlson AR(1) model, the Ohlson AR(2) model severely underestimates market prices even relative to book values. These results further bring into question the empirical validity of the Ohlson model. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Quantitative Finance and Accounting Springer Journals

Linear Accounting Valuation When Abnormal Earnings Are AR(2)

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Publisher
Kluwer Academic Publishers
Copyright
Copyright © 2001 by Kluwer Academic Publishers
Subject
Finance; Corporate Finance; Accounting/Auditing; Econometrics; Operation Research/Decision Theory
ISSN
0924-865X
eISSN
1573-7179
D.O.I.
10.1023/A:1011255602608
Publisher site
See Article on Publisher Site

Abstract

The Ohlson (1995) model assumes that abnormal earnings follow an AR(1) process primarily for reasons of mathematical tractability. However, the empirical literature on the Garman and Ohlson (1980) model finds that the data support an AR(2) lag structure for earnings, book values and dividends. Moreover, the AR(2) process encompasses a far richer variety of time series patterns than does the AR(1) process and includes the AR(1) process as a special case. This paper solves the Ohlson model directly for an AR(2) abnormal earnings dynamic. The model is estimated on a time series firm-level basis following the approach used by Myers (1999). It is found that, like the Ohlson AR(1) model, the Ohlson AR(2) model severely underestimates market prices even relative to book values. These results further bring into question the empirical validity of the Ohlson model.

Journal

Review of Quantitative Finance and AccountingSpringer Journals

Published: Oct 3, 2004

References

  • An Empirical Assessment of the Residual Income Valuation Model
    Dechow, P. M.; Hutton, A. P.; Sloan, R. G.
  • Industry Costs of Equity
    Fama, E. F.; French, K. R.
  • Valuation and Clean Surplus Accounting for Operating and Financial Activities
    Feltham, G. A.; Ohlson, J. M.

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